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There’s no one-size-fits-all solution in the investment world. Each product has its own pros and cons, just as each person has a unique set of traits. Structured notes can have a place in the portfolio of certain investors. In general, structured notes are a worthwhile investment for folks seeking defined-outcome strategies or those who want to actively manage risk better.
Comprised of a bond and a derivative component, structured notes are often used to increase a portfolio’s income yield and protect against a downturn in the stock market. They also help reduce volatility, which can be a behavioral win that helps investors stick with a broader allocation strategy.
Structured notes have a bad rap, though, due to the sometimes-high costs that are embedded in the products. With more money coming into the space, some costs have come down. There is no stated expense ratio as there is for, say, a mutual fund or ETF, however.
Critics also claim that structured notes are more complex and difficult to manage throughout their lifecycle than they are worth. Still, understanding what structured notes are, how they are used, and what types of investors might consider them is key to determining if they are a good investment for an individual’s situation.
What Is a structured note?
A structured note is an investment vehicle with stock- and bond-like characteristics. It generally plots between equities and fixed income on a risk-and-return graph. Considered a debt instrument and issued by major financial institutions, there is a maturity date, an interest rate, an underlying asset or index, a protection level, and a return or payoff percentage.
The bond piece provides a level of income, while the options package creates a tailored payoff profile, including upside and downside exposure to the underlier. The bond’s maturity sets the time horizon of the structured note and derivatives are in place to provide either hard or soft protection. There are growth and income notes – generally, more aggressive investors will go for the former while risk-sensitive individuals may be more likely to own the latter.
Many investors are curious about what type of structured note is best for them. They must first have a handle on the underlying asset or index. Most notes track the price performance of an equity index, such as the S&P 500. Others may be linked to the performance of a basket of commodities, interest rates, inflation, currencies, and more. Investing in structured notes can also be done using individual stocks as the underlying asset. With more than $3 trillion in assets invested in structured notes worldwide, demand is on the rise, and new types of structured notes with improved liquidity have proliferated.
Structured note example
Structured notes offer investors upside participation in an underlier with a defined outcome – percentage returns under various scenarios. A hypothetical example of how payoffs are constructed will illustrate if a structured note is right for you.
Consider a callable principal-protected structured note tied to the performance of the S&P 500. It has a five-year maturity and pays a fixed interest rate of 9% per year. The structured note issuer may redeem the note starting one year from its creation. The terms could state that if the S&P 500 remains 10% above the level from the issuance of the note, then it will pay the 9% annual coupon.
If it falls below the 10% buffer threshold, then the note loses value on a one-for-one percentage basis. So, even if the S&P 500 drops 20%, the investor still outperforms by 10 percentage points. If the market rallies, the noteholder will collect the high yield but not the appreciation in the stock market or the S&P 500’s dividend. The principal is protected and guaranteed by the issuer – the investor is paid back the initial investment at the five-year maturity mark.
Investing in structured notes: Who should consider them?
It’s difficult to pin down who precisely should look at owning a specific investment, particularly a complex product like a structured note. At a high level, risk-conscious investors, such as people approaching or in retirement, are often attracted to structured notes as a replacement for stock or bond exposure. The appeal is that there’s a guaranteed income with defined outcomes. Structured notes are a protective investment compared to owning stocks and often have a higher coupon yield than bonds and fixed-income exchange-traded funds (ETFs).
Who should not invest in structured notes? In general, young investors and those without a target time horizon or income requirement as part of their goals have little business considering structured notes. Rather, sticking with a strategy of investing in the stock market through low-cost ETFs may do them just fine. If, however, a young person is saving for a down payment on a house within a few years, then owning a structured note to reduce equity risk could be a savvy move. A structured note maturing near the time of the home purchase could work.
When evaluating structured notes as an investment, advisors often call out the poor tax treatment. While there may be a high interest rate on a note, this specific investment can get ugly when it comes to paying Uncle Sam his share. Income is generally taxed at ordinary-income tax rates. Owning structured notes within a tax-sheltered account like an IRA might make sense for those seeking to bypass some of the unfavorable tax treatment.
Risks of investing in structured notes
The advantages of investing in structured notes are straightforward: a high income yield with defined outcomes. Along with the undesirable tax treatment, structured notes feature other negative aspects, making them unappealing for people desiring a super-simple allocation.
For example, the interest rate and maturity date of a structured note are unique to it. Upon each maturity or when a note is called, the investor or advisor handling the account must actively reinvest the proceeds into something new. That’s not only a hassle and a time commitment but also introduces reinvestment risk – by the time the cash arrives, market conditions may have shifted considerably.
And have you ever tried to sell a structured note? That can be a burdensome process if you are doing it through the note issuer – the bank may not want to buy it back. The good news here is that a secondary market may be available through investing platforms. What’s more, as new issuers enter the arena, liquidity trends could be on the rise over the coming years. Still, selling a structured mote before its maturity date will probably result in an execution price that is less than favorable.
Structured notes’ performance is often tied to the S&P 500 or another stock index. If that index performs poorly, you could still lose money. Finally, credit risks are apparent if the issuing bank goes into default – the noteholder might not be paid a coupon in a given period or they could even lose their principal.
The bottom line
Many among of the investor population should avoid the risks of structured notes. But for certain individuals, owning them makes sense. Retail investors are well served teaming with an advisor adept at transacting and handling structured notes. Structured notes offer defined outcomes that have behavioral benefits for risk-conscious investors, and there are many types of structured notes to fit an array of investor needs.
Dr. David Townsend, CFA, leads product marketing and thought leadership at Halo Investing. He’s responsible for helping advisors articulate how portfolios can benefit from defined-outcomes and other alternative strategies. By helping arm advisors with unique insights and confidence, they become more comfortable securing wealth with more than just stocks and bonds.
An investment in Structured Notes may not be suitable for all investors. These investments involve substantial risks. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Halo Investing is not a broker/dealer. Securities offered through Halo Securities LLC, na SEC registered broker/dealer and member of FINRA/SIPC. Halo Securities LLC is affiliated with Halo Investing Insurance Services and Halo Investing. Halo Securities LLC acts solely as distributor/selling agent and is not the issuer or guarantor of any structured note products.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
